What is a QBI Deduction?

by Jennifer Kiesewetter in September 7th, 2021

TLDR

  • The Qualified Business Income (QBI) deduction was passed as part of the Tax Cuts and Jobs Act of 2017.
  • The QBI deduction is for business owners who have pass-through income, meaning they report their business income on their personal taxes. Examples of pass-through entities include sole proprietorships, partnerships, S-corporations, and LLCs.
  • The QBI deduction is a federal tax deduction allowing self-employed individuals and small businesses with pass-through income to deduct on their taxes up to 20 percent of qualified business income, plus “20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.”
  • Generally, to take the deduction for the 2021 tax year, the founder’s income must be less than $164,900 for single filers and $329,800 for joint filers.
  • To calculate your QBI deduction, first, calculate your business income and expenses on Schedule C of Form 1040. Then you calculate your adjusted gross income, also on Form 1040. After those calculations are finished, then you can calculate the QBI deduction.
  • However, it’s not as simple as it may seem. The complete calculation, and your startup’s eligibility for the deduction, involves a complicated, multistep process that may “phase out some or all of the deduction.”
  • When calculating your QBI deduction, you’ll need to account for your startup’s qualified property. Under the Internal Revenue Code, qualified property essentially means tangible, appreciable property. However, like other aspects of this tax deduction, limitations exist for qualified property as well. 
  • A QBI deduction is known as a “below the line” deduction on your personal taxes., meaning that the QBI deduction is applied after you (or your accountant) calculates your adjusted gross income on your Form 1040.
  • As such, you’ll enter your QBI deduction on Line 10 of Form 1040. Your QBI deduction will then be subtracted from your adjusted gross income, resulting in your taxable income. Additionally, to claim the QBI deduction, you’ll have to include either a Form 8995 or Form 8995-A with your tax filing.
  • Suppose founders want to take advantage of this tax deduction, and they qualify to take it. In that case, it’s important to note that this deduction is only available until December 31, 2025, unless Congress decides to extend it.

Launching a startup can often feel exciting and nerve-wracking all at once. Between product development, sales strategies, and staying on top of your investors’ expectations, it seems like your to-do list is never-ending.

Staying on top of the newest tax laws is probably not on that list. But it should be. Understanding what taxes your startup owes in addition to what expenses are deductible directly impacts your cash flow and your bottom line.

In this article, we’re going to explore the Qualified Business Income (QBI) deduction, passed as part of the Tax Cuts and Jobs Act of 2017.

What is QBI Deduction?

The QBI deduction is a federal tax deduction allowing self-employed individuals and small businesses with pass-through income—such as sole proprietorships, partnerships, and limited liability companies (LLCs)—to deduct on their taxes up to 20 percent of qualified business income, plus “20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.”

However, according to the Journal of Accountancy, the complete calculation involves a complicated, multistep process that may “phase out some or all of the deduction.”

Let’s break this down.

Essentially, the QBI deduction can significantly reduce the taxable income for those pass-through entities that qualify under the recent law. Note that it does not lower the tax rate per se; it lowers the business’s taxable income, lowering the founder’s tax bracket. Although a fine distinction, it’s an important one.

Generally, to take the deduction for the 2021 tax year, the founder’s income must be less than $164,900 for single filers and $329,800 for joint filers. However, each year, the threshold amounts may be adjusted for increased cost of living by the Internal Revenue Service.  

Suppose you’re over the income limits, whether as a single or joint filer, you’ll have to run through some more tests to see if you qualify for the QBI deduction. For example, suppose you offer professional services, such as legal, medical, or financial services. In that case, your startup may be deemed a specified service trade or business (SSTB) and may not qualify as the founders and owners exceed the compensation limits. However, if you operate an SSTB, but your income falls below the compensation levels for the specified tax year, then you may be eligible for the entire QBI deduction, despite your SSTB status.

In other situations, you may be able to take part in the QBI deduction, but not all, even if you exceed the compensation limits mentioned above.

Now to the specifics of this federal tax deduction.

Who Qualifies for the QBI Deduction?

As we stated above, the QBI deduction is for business owners who have pass-through income, meaning they report their business income on their personal taxes. Examples of pass-through entities include sole proprietorships, partnerships, S-corporations, and LLCs.

Additionally, some estates and trusts may also take the QBI deduction; however, C-corporations are not permitted to take this deduction as those entities are not pass-through entities for taxation purposes.

The founders may take the QBI deduction for eligible entities, whether they take a standardized deduction or itemize their deductions on their personal taxes.

How to Calculate QBI Deduction

Now, to the calculation of the QBI deduction.

When calculating the 20 percent deduction, founders need to keep the following in mind:

  1. As stated above, the QBI deduction can equate to 20% of your startup’s taxable business income. However, it cannot add up to more than 20 percent of your taxable business income when claiming this deduction. So, for example, you calculate your business income and expenses on Schedule C of Form 1040. Then you calculate your adjusted gross income, also on Form 1040. After those calculations are finished, then you can calculate the QBI deduction.
  2. Additionally, as stated above, if you use the standard deduction instead of itemizing your business deductions, you may still be eligible for the QBI deduction.
  3. The QBI deduction is also “subject to limitations, depending on the taxpayer’s taxable income, that may include the type of trade or business, the amount of W-2 wages paid by the qualified trade or business and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business. It may also be reduced by the patron reduction if the taxpayer is a patron of an agricultural or horticultural cooperative.” Together, numbers 1 through 3 make up the first component of the QBI deduction. Now to the second component, which may or may not apply to you and your startup.
  4. The second component of the QBI deduction relates to the “20 percent of qualified REIT dividends and qualified PTP income.” According to the Internal Revenue Service (IRS), this component is not limited by W-2 wages or UBIA of qualified property, as is true with the QBI deduction.

In determining how much of a deduction the founder may take, this second component is “limited to the lesser of the QBI component [specified in steps 1-3 above] plus the REIT/PTP component or 20 percent of the taxable income minus net capital gain.”

For purposes of the QBI deduction, we’ll discuss what qualified property is later in this article.

What is Qualified Business Income?

When determining whether your startup is eligible to take the QBI deduction, you must understand what is included in qualified business income.

Essentially, your QBI is your startup’s net profit.

Specifically, QBI is “the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts. These includable items must be effectively connected with the conduct of a trade or business within the United States.”

Further, when calculating QBI, be sure to include any deduction attributable to your startup. For example, be sure to account for “the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans (such as SEP, SIMPLE and qualified plan deductions),” according to the IRS.

On the other hand, QBI does not include wage income, interest or income not associated with your startup, amounts received as compensation from an S-corporation, amounts received as guaranteed income from partnerships, qualified REIT dividends, or qualified PTP dividends.

When calculating your QBI deduction, be sure to consult with an experienced accountant, as the calculation itself may be complicated depending on your startup.

What is Qualified Property for QBI?

When calculating your QBI deduction, you’ll need to account for your startup’s qualified property. Under the Internal Revenue Code, qualified property essentially means tangible, appreciable property. However, like other aspects of this tax deduction, limitations exist for qualified property as well. 

For example, the property may not be considered for this deduction if it is acquired within 60 days before the end of the tax year for which you want to take the QBI deduction, according to the CPA Journal. So, the timing of purchasing or selling property may impact your QBI eligibility.

Rental property income might be considered qualified property if the business or rental income qualified as trade or business income under Internal Revenue Code Section 162.

Where is QBI Deduction Reported?

A QBI deduction is known as a “below the line” deduction on your personal taxes., meaning that the QBI deduction is applied after you (or your accountant) calculates your adjusted gross income on your Form 1040.

As such, you’ll enter your QBI deduction on Line 10 of Form 1040. Your QBI deduction will then be subtracted from your adjusted gross income, resulting in your taxable income. Additionally, to claim the QBI deduction, you’ll have to include either a Form 8995 or Form 8995-A with your tax filing.

Some Final Notes

  • Because a QBI deduction is taken on your personal tax filing, it’s not considered a business deduction. Therefore, it does not impact the amount you pay in self-employment tax.
  • If you have multiple businesses, you may be eligible for taking a QBI deduction across all of your companies, depending upon your business income and the limitations described above.
  • Suppose founders want to take advantage of this tax deduction, and they qualify to take it. In that case, it’s important to note that this deduction is only available until December 31, 2025, unless Congress decides to extend it.
  • In 2018, the first year that businesses could take the QBI deduction, the IRS found that almost 900,000 tax returns were filed with no QBI deduction claimed, even though those businesses were eligible for it. So seeking professional guidance when it comes to your startup and its taxes can pay off—literally—boosting your startup’s bottom line and keeping some money in your pocket.

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Note: Our content is for general information purposes only. AbstractOps does not provide legal, accounting, or certified expert advice. Consult a lawyer, CPA, or other professional for such services.

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